Deconstructing Pop Culture

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Two Stops at One Stops

September 10th, 2006 by David Kronemyer · No Comments

I’m going to tell you a couple of interesting stories about one-stops. But, before I do, I have to tell you what a one-stop is, and how it fits into the record biz food chain. If you know this already, or it’s too boring, please feel free to skip ahead.

It goes without saying that the U.S. record industry has changed dramatically over the past several years, and that it will continue to do so. One of the ways in which it has changed, is the different composition of the customer base for records. By “customer,” I don’t mean “consumers,” the people who actually buy and listen to records. Rather, I mean transactional intermediaries – wholesalers and retailers – which buy records from the record companies, and then in turn sell them to consumers.

In the 1970s – early 1980s, most record company distributors had over 10,000 separate customer accounts. These parsed out into four essential types:

1. Individual stores, sometimes referred to as “mom-and-pops,” even though they were not necessarily owned by mothers-and-fathers.

2. “Central warehouse retailers,” which were large chains, such as Musicland or Transworld. They were called “central warehouse retailers” because they took records in to one or two main locations (the “central warehouse”), and then re-distributed them to each of their individual stores (which typically were in shopping malls), depending upon each individual store’s needs and requirements. Significantly, the economic characteristics of the central warehouse retailer are no different than those of the mom-and-pop retailer, in the sense that both are the last point where records stop, before their sale to consumers. While the central warehouse retailer moves records around its system, it simply is shipping records to itself; in economic terms, it is not a wholesaler, even though it performs many of the same functions. The economic scale of the central warehouse retailer, of course, is much larger than that of the mom-and-pop.

3. “Rack-jobbers,” of which there were two, Handleman and Lieberman. The rack-jobber essentially was responsible for record sales at a large chain store, such as Kmart, which found it more economical and efficient to sub-contract its entire record sales operation to a third-party vendor. As the entity responsible for all record sales activity within the chain store, the rack-jobber would be in charge of every aspect of that department’s operations, from inventory management, to sales and marketing, to returns. Unlike the central warehouse retailer, the rack-jobber was a true wholesaler, because the transaction in which the distributor sold the records to the rack-jobber, was economically distinct from the transaction in which the rack-jobber in turn sold the records to the retailer.

Because it was a true wholesaler, the rack-jobber typically received a price discount in the range of 10% – 12%, which was its operating margin. While the Robinson-Pattman Act prohibits price discrimination, it has several exceptions, one of which is the “functional” discount. Wholesalers justified their lower price, because they performed a “break bulk” function – they took orders from their customers, and re-distributed inventory. Retailers, at least in principle, did not undertake this type of activity.

4. Then, there were the “one-stops.” The role of the one-stop is implied by its name; originally, it was intended as a place where individual stores, too small to be opened up as direct-purchase customers by the record company, could buy (and return) records. Over time, one-stops also became places where the individual store locations of large central warehouse retailers could replenish stock, the need for replenishment having been caused by unexpected consumer demand for a particular title, or by an inefficient supply chain from the central warehouse retailer’s own warehouse(s). As a wholesaler, the one-stop also received a functional discount.

During the late 1980s – 1990s, this schematic underwent profound structural change. Record companies slashed their customer rosters, ending up with less than a tenth of what they started out with, and the top 10 customers came to comprise some 85% of sales. As a result of these (and other) developments in the marketplace, record companies abandoned their two-tiered pricing model, and began charging one, single wholesale price to all of their customers. Factors precipitating this change include:

1. The rise of large, “category-killer” stores, like Tower, Virgin and HMV. These stores were unlike central warehouse retailers, in that (mainly) they were huge, stand-alone locations. They were not fulfilled from a central warehouse, but rather, drop-shipped by the distributor, directly to each individual store. Because of their high volume of transactions, they were valuable customers; yet, because they were not wholesalers, they were not entitled to receive a lower price, based upon the logic of the “functional discount.” Over time, they became highly disgruntled, and demanded to receive the lowest price offered.

Record companies devised several ruses to circumvent the Robinson-Pattman Act’s requirement of a single price, such as “meeting competition,” which is another one of the Act’s exemptions. The theory of meeting competition is that a manufacturer is not required to stand by idly while it is priced out of the market by its competitors; it should be, and is, entitled to extend to its customers, the same price as its competitors, for analogous product. As you might imagine, this leads to several difficulties, such as (a) adequately establishing the existence of the lower, competitive price; (b) at least in principle, record releases are not fungible – for example, only one company can sell a particular title by the Beatles, or the Rolling Stones, thus the concept of “competition” is somewhat shaky, to begin with; and (c) over time, the industry had to face claims of collusion and price-fixing, as all of the supposedly “competitive” prices tended to march in lock-step, varying only by a few pennies in either direction.

Around the same time as the category-killers, a new type of retailer emerged, which is the medium-sized retailer – neither a mom-and-pop, nor a central warehouse retailer, nor a large, category-killer type of store, but something in-between. It may have started off as a single store, and then expanded into a small chain; or, evolved in some other way. But, all of a sudden, it became a dominant presence in a particular market, a kind of “hipper” place for the cognoscenti to buy records, with the ability to influence consumer tastes through effective marketing and promotion. These companies, too, wanted a lower price.

2. Economies of scale. As a parallel development, computer technology became more sophisticated. For the first time, record companies were able to track accurately their internal cost of servicing marginal customers. Many of the smaller, “mom-and-pop” retailers were unable to keep up, economically, and simply went out of business. Correspondingly, one-stops consolidated; those that survived became larger, because now they were servicing a greater volume of customers, which each record company formerly had dealt with, directly.

Because of new computer technology, record companies increasingly became aware of inventory management issues. Contrary to what you might think, obsolete records – those that are manufactured, but never sold – are not “assets.” Rather, they represent a huge liability. Many record companies were chagrined to learn that they had a 10 or 20 year supply of some titles, based on the title’s product life cycle. These unsold records are costly to account for, and store. Quick manufacturing turn-around, typically less than a week, makes it possible for the record company to respond efficiently to sudden outbreaks of consumer demand; it isn’t necessary to hold on to a large supply of stock.

Much of this stock was “in the field” – records that have been sold to customers, but not yet purchased by consumers. One of the distinguishing features of the record company’s sale of a record to a customer, is that the record is returnable by the customer, for full credit against the customer’s applicable purchase price. This isn’t a “consignment sale,” even though it looks a little bit like one, because the customer actually has to pay for the record. Rather, at least initially, it was thought that a return privilege would induce the customer to take in a greater quantity of records, that may have a speculative sales provenance. The customer knew that if that particular record didn’t sell, it could be returned for one that did, either by a new artist, or an established one.

In fact, a good argument can be made that one of the primary strengths of a solid catalog of back-titles isn’t so much its “raw” sales potential; but, rather, the security it gives to sales of new releases, by under-pinning the economic value of a potential return. Conversely, distributors with little catalog (such as several of the “independent distributors,” in various eras of record company history) have found it difficult to lay out an adequate spread of new releases, simply because customers are skeptical of their value, as a return.

Over time, return privileges became an ingrained feature of the transaction between the record company and its customer, even if the artist was well-established in the marketplace. This led to a massive “overhang” of inventory that was “sold,” as far as the record company was concerned, but that could become “unsold,” quickly.

Don’t get me wrong, I don’t think that returns are inherently bad, which is the view held by some. If you don’t have some returns, it means you didn’t spread the record wide enough, to begin with – you were too conservative, or under-estimated the capability of your marketing and promotional staff to stimulate consumer interest. Returns are bad only when the record is heavily laid out into the field, with no reasonable prospect that it’ll sell through. In the record biz, this phenomenon is known as “shipping gold, returning platinum.”

The quantity of stock “in the field” is immense. If we imagine that finished goods records went away, overnight, to be replaced by their digital, on-line counterparts, it is likely that most record companies would go bankrupt, as they would have to accommodate, and credit to their customers, a massive volume of product returns. Indeed, this probably is one of the reasons why record companies have been so slow to respond to the changing dynamics of the on-line marketplace; they are wedded to an obsolete, “finished goods” model, based upon their long-standing financial (and credit) relationships with large retailers.

3. The rise of “virtual stores,” such as Amazon.com. As the Internet era came of age, more and more consumers became “turned off” by the typical retail environment, and found it more convenient to order records by mail from an on-line store, rather than visiting a physical “bricks-and-mortar” retail store location. “Virtual stores” have a significant economic advantage over “bricks-and-mortar” stores, in that it is not necessary for them to maintain separate inventories of each title at separate physical store locations. Rather, they simply can stock a few copies of slower-selling titles at one, single, consolidated place.

So right about now you’re probably feeling pretty knowledgeable about record retailing, returns, and similar matters. You’re now in a position to savour our first one-stop story, which involves a rather smaller one-stop, obviously deteriorating in the new, competitive environment. It had put out word to its customers that it would accept returns of all records, even if the records hadn’t originally been purchased from the one-stop. This probably happens a lot, anyway, since there’s nothing preventing a retailer from having a relationship with more than one one-stop; and, records don’t come with little signs on them, saying, “I was purchased from thus-and-such a one-stop.”

But these guys had gone way overboard. They were returning, to the record company, a volume of records far in excess of purchases from the record company. In other words, the one-stop was receiving a credit (from the record company) for records it never had sold, to begin with. But the situation was even worse than this, because the record company had yet to adopt an accounting system that would enable it to track initial sales discounts. It’s common for new releases, for example, to be sold at some discount off of the wholesale price – say, 5% to 10%. Thus, the one-stop was receiving a credit for the full wholesale price, even for records it initially had purchased, at an invoice discount.

This had turned into quite a lucrative business for the one-stop. It had added extra staff. It had acquired a “shrink-wrap” machine, enabling it to refurbish shop-worn inventory, and make it look “like new,” so it could be returned to the record company, without suspicion.

After we found out about this, we were pretty pissed off. So, the Vice President of Sales and I determined to do something about it. Now, you have to understand that I love this guy who was V.P. of Sales. A truer, more “salt-of-the-earth,” street-wise, hard-bit, smart-in-all-of-the-wily-ways-of-customers and genuine all-around nice guy, you ain’t gonna find nowhere. He and I actually made a pretty good team, ‘cause I’d come in being all official and everything, and then he’d basically come in swinging a baseball bat. Every time we did this little Tom & Jerry show, it had pretty effective results.

So, on one bright spring morning, we both got into the car and motored on over to the one-stop. Unannounced. We walked right in like we owned the place, and all work halted. Especially the guys who were re-shrinking the records. This guy came stumbling out of his office, and got the picture pretty quick that something was up. We sat him down, explained our business, and politely suggested that this sh*t had better stop, and quick.

And you know what, within a week, returns from that one-stop were back in normal mode, running about 15% of sales overall.

The second incident occurred when our record company bought the assets of another record company, that previously had been distributed by one of our competitors. I was integrally involved with the transaction.

Two of the issues that always come up with these deals are, what to do with records that are “out in the field,” i.e., in the hands of wholesalers and retailers, waiting to be sold; and, what to do with finished goods inventory “on hand” at the prior distributor’s warehouse. After the closing of the acquisition transaction, both classes of records will have the wrong SKU (which stands for “shop-keeper’s unit”), or “bar-code” – they will bear the bar code of the predecessor distributor, not that of the successor distributor.

This makes them difficult to handle, for at least two reasons. First, it interferes with order fulfillment, because the physical goods have a SKU that doesn’t match the new SKU appearing in catalogs, order forms, promotional materials, returns authorizations, and such. Second, it interferes with returns administration, because it makes it more likely the inventory will be returned to the old distributor, which no longer will have any economic responsibility to credit the return.

So, what usually happens, is that the successor distributor agrees to take returns of all of the old records, even those initially sold by the former distributor. There is some inequity in this process, because the successor distributor must credit a return on account of a sale that it never made (rather, that sale was made by the predecessor distributor). However, (a) this always is reflected in the purchase price, or as a potential reduction of the purchase price, if the volume of returns from the field is greater than anticipated (usually due to lying, or poor book-keeping, by the company being acquired); and, (b) there has been such a volume of record labels being bought and sold lately, that it’s as likely you’ll end up being the buyer, as the seller, so, over time, it all tends to even out. It’s actually a good thing to keep the customer base feeling snug and cozy; the more confident they are about their ability to make a return, the less likely they are to make it.

As far as inventory in the warehouse goes, you’ve got two options. The first is to re-sticker it; and, the second is just to throw it out. Re-stickering seems like it’d be the first choice – but, if you’ve been paying attention, you’ll know that most of that inventory is obsolete, anyway. After all, there’s a reason why that particular company is being sold, and too much obsolete inventory probably is one aspect of the equation, no matter how hard you look elsewhere! Stickering obsolete inventory only is compounding the error of keeping the inventory around, in the first place. So, the best thing to do, usually, simply is to scrap it.

And this is exactly the decision that was made in the case of my next little story. Instead of scrapping it, though, some bright-idea bureaucrat at the acquiring record company got it into his (or her) head, that it would be more “ecologically sound” if all of this inventory was “recycled.” After all, the CDs contain potentially toxic chemicals, the jewel boxes are made of plastic, the paper inserts are made out of trees, and blah blah blah. So, there came a nice fine day when all of the inventory – and we’re talkin’ a huge quantity of stuff – went off to the recyclers.

Or, so we were told. The fact of the matter, however, is that it never made it to the recyclers. Rather, it was diverted – somewhere along the way – by whom I shall not say – and most of it ended up in the hands of (you guessed it) one of our nice one-stops (not the same one as in the first episode). We became aware of the fact that the obsolete inventory was “missing” soon after the event occurred. It took us a while to trace it down to this particular one-stop.

Here are the potential economic consequences, if these records ever actually got out into the chain of commerce:

1. If they were sold to retailers, and then sold through to consumers, and not returned, then the one-stop would keep the entire purchase price from its retailer-customer, because it never had paid for the goods (at least, it never had paid us).

2. On the other hand, if they were not sold to retailers, then the one-stop could return them to us, and, once again, get full credit against a price they never had paid. We, in turn, would be economically disadvantaged, because this was not “field inventory” that could be set-off against the purchase price for the company. Rather, it was warehouse inventory, which both parties had agreed would be destroyed, and we were the ones responsible for its destruction.

So, my V.P. of Sales and I determined that we’d have to make another one of our little excursions. We saddled up and motored off. This time we also had some law-enforcement back-up, as the friends and colleagues with whom we would be meeting had, shall we say, a bit of a reputation for rough play, and we wouldn’t want any trouble now, would we?

We got to their warehouse, walked inside, and introduced ourselves. There, lying before us, stacked to the ceiling, were hundreds of pallets of CDs – tens of thousands of CDs, in all. “Funny,” the V.P. of Sales said, “you guys must really be doing great, to have all of these CDs in stock!” They replied: “mumble, mumble, mumble.” We walked over and took a look at some of the titles. Sure enough, all of them were the “old” inventory, that originally had been destined for recycling. “And what a coincidence,” V.P. of Sales continued, “it all seems to be our stuff!” Once again, they replied, “mumble, mumble, mumble.”

Within four hours we had the entire inventory loaded onto a half-dozen large trucks. We took it back to our distribution center. And me and the V.P. of Sales drank about a case of beer while we watched them grind it up, carton by carton. While we were oblivious to any potentially adverse ecological impact, we certainly were aware that we had intercepted a multi-million dollar inventory issue.

So don’t let anybody go around “recycling” your inventory, OK?